1 The Monetary System  Establishes two different types of standardization in the economy Unit of value—a common unit for measuring how much something is worth - refers to the way we think about and record transactions Means of payment—things we can use as payment when we buy goods and services - refers to how payment is actually made  In United States, the dollar is centerpiece of our monetary system

2 History of the Dollar  How did the dollar come to play such an important role in the economy?  Prior to 1790, each colony had its own currency Called the “pound” in every colony, but it had a different purchasing power in each of them In 1790 Congress created a new unit of value called the dollar  Primary means of payment in United States until Civil War was paper currency issued by private banks  However, during Civil War government issued first federal paper currency—greenback Functioned as both unit of value and major means of payment until 1879  In 1913, a new institution was created to be the national monetary authority in United States -Federal Reserve System - the central bank and national monetary authority of the United States

3 Why Paper Currency is Accepted as A Means of Payment  Paper currency is a relatively recent development in the history of the means of payment  Earliest means of payment were precious metals and other valuable commodities such as furs or jewels Called commodity money because they had important uses other than as a means of payment  Commodity money eventually gave way to paper currency  Today paper currency is no longer backed by gold or any other physical commodity This type of currency is called fiat money  Fiat, in Latin, means “Let there be,” and fiat money serves as a means of payment by government declaration  While government can declare that paper currency is to be accepted as a means of payment, it cannot declare the terms  Value of the dollar—its purchasing power—does change from year to year Reflected in changing prices of things we buy

4 Measuring the Price Level and Inflation  Microeconomic causes—changes in individual markets—can explain only a tiny fraction of price change For the most part, price rises came about because of a continually rising price level  Average level of dollar prices in the economy  100 years ago one pound of coffee was 15 cents, new suit - $6, private college tuition for 1 year -$200

5 Index Numbers  Most measures of the price level are reported in the form of an index Series of numbers, each one representing a different period  In general, an index number for any measure is calculated as Compress and simplify information so that we can see how things are changing at a glance

6 The Consumer Price Index  Consumer Price Index (CPI) is an index of the cost, through time, of a fixed market basket of goods purchased by a typical household in some base period  Most widely used measure of the price level in United States Designed to track price paid by typical consumer Compiled and reported by Bureau of Labor Statistics (BLS)  Two problems must be solved before we even begin Must decide which goods and services should be included in average How to combine all the different prices into a average price level- would be a mistake to use a simple average of all prices – a proper measure must recognize that we spend very little of our incomes on some good and much more on others.  CPI’s approach is to track cost of CPI market basket Collection of goods and services typical consumer bought in some base period market basket’s cost rise by x percent implies the price level, as reported by the CPI, will increase by x percent.

7 From Price Index to Inflation Rate  Consumer Price Index is a measure of the price level in the economy Inflation rate measures how fast price level is changing, as a percentage rate When price level is rising, as it almost always is, inflation rate is positive When price level is falling, as it did during Great Depression, we have a negative inflation rate  Called deflation

8 How the CPI is Used  CPI is one of the most important measures of performance of the economy  Used in three major ways As a policy target  Measure most often used to gauge our success in achieving low inflation To index payments  A payment is indexed when it is set by a formula so that it rises and falls proportionately with a price index To translate from nominal to real values  In order to compare economic values from different periods, we must Translate nominal variables  Measured in the number of dollars Into real variables  Adjusted for the change in dollar’s purchasing power  CPI is often used for this translation

9 Figure 1: The Rate of Inflation Using the Consumer Price Index, Annual Inflation Rate (%)

10 Real Variables and Adjustment for Inflation  Suppose that from December 2004 to December 2005, your nominal wage rises from $15 to $30 per hour Are you better off?  That depends To track your real wage, need to look at number of dollars you earn relative to price level  Real wage formula is as follows

11 Real Variables and Adjustment for Inflation  Important point When we measure changes in macroeconomy, we usually care about purchasing power those dollars represent  Not about the number of dollars we are counting  Translate nominal values into real values using the formula How most real values in the economy are calculated –One important exception To calculate real GDP, government uses a different procedure

12 Inflation and the Measurement of Real GDP  A special price index called GDP price index is calculated for GDP  Most important differences between CPI and GDP price index Types of goods and services covered by each index  GDP price index includes some prices that CPI ignores GDP price index excludes some prices that are part of CPI  Can summarize chief difference between CPI and GDP price index GDP price index measures prices of all goods and services that are included in U.S. GDP While CPI measures prices of all goods and services bought by U.S. households

13 The Inflation Myth  Most people think inflation erodes average purchasing power of income By making goods and services more expensive However, this statement is mostly wrong  Loss in buyers’ real income is matched by the rise in sellers’ real income  Inflation may redistribute purchasing power from one group to another But it does not decrease average real income when we include both buyers and sellers in the average  Often blame inflation for lowering our purchasing power when the real cause lies elsewhere

14 The Redistributive Cost of Inflation  One cost of inflation is that it often redistributes purchasing power within society – not generally desirable – sometimes harming the needy, helping those who are already well off.  How does inflation sometimes redistribute real income? An increase in price level reduces purchasing power of any payment that is specified in nominal terms  Inflation can shift purchasing power away from those who are awaiting future payments specified in dollars Toward those who are obligated to make such payments  Does inflation always redistribute income from one party in a contract to another? No—if inflation is expected by both parties, it should not redistribute income

15 Expected Inflation Need Not Shift Purchasing Power  Over any period, percentage change in a real value (%Δ Real) is approximately equal to percentage change in associated nominal value (%Δ Nominal) minus the rate of inflation %ΔReal = %ΔNominal – Rate of Inflation  If inflation is fully anticipated, and if both parties take it into account, then inflation will not redistribute purchasing power  When inflation is not correctly anticipated, however, our conclusion is very different  Nominal interest rate Annual percent increase in a lender ’ s dollars from making a loan  Real interest rate Annual percent increase in a lender ’ s purchasing power from making a loan  In absence of inflation, real and nominal interest rates would always be equal

16 Unexpected Inflation Does Shift Purchasing Power  When inflationary expectations are inaccurate Purchasing power is shifted between those obliged to make future payments and those waiting to be paid An inflation rate higher than expected harms those awaiting payment and benefits the payers An inflation rate lower than expected harms the payers and benefits those awaiting payment In lender-borrower example, unexpected inflation has led to better deal for your borrower and a worse deal for you as a lender

17 The Resource Cost of Inflation  Inflation imposes an opportunity cost on society as a whole and on each of its members When people must spend time and other resources coping with inflation they pay an opportunity cost  Sacrifice goods and services those resources could have produced instead  Resources used by consumers to cope with inflation Time you could have spent earning income or enjoying leisure activities